Synthetic Exchange-Traded Funds (ETFs) look to replicate the performance of a given index by entering into a total return swap (TRS) agreement with an investment bank. The bank agrees to pay the ETF the return on its benchmark index in exchange for the return on the cash held by the ETF. Collateral is used to mitigate the counterparty risk associated with these swaps.

However, hedging synthetic ETF positions using TRS can pose several significant challenges for issuer banks when it comes to collateral management. Chief amongst these are regulatory considerations. For instance, synthetic ETFs domiciled in Europe and aiming to comply with UCITS (Undertakings for Collective Investment in Transferable Securities) must ensure that the exposure to any single counterparty through a TRS cannot exceed 10% of the fund’s assets, creating a challenge around diversification.

Another challenge comes from investment guidelines. Collateral received under a TRS must be consistent with the fund’s investment objectives. For example, a fund that is designed to track a specific sector or market cannot accept collateral that deviates significantly from that sector or market. Guidelines also set thresholds for the percentage of assets that must be immediately liquid. This can be challenging in stressed market conditions where certain assets become less liquid.

Until now, these and other challenges around collateral management in synthetic ETFs have been addressed using time-consuming and risky manual processes. In this approach, traders use spreadsheets and other outdated systems to extract collateral management data before communicating with clients individually and sequentially. The approach is slow and open to error, driving up costs and increasing risk for banks and their clients. 

Fortunately, the market is now responding with new, digital-first alternatives that promise to reduce risk and drive efficiencies in banks. The Wematch Synthetic ETF module is a good example of the type of innovation that will deliver breakthrough results in this space. 

Broadly speaking, the module consolidates collateral management and automates optimisation processes. As part of this, the module seamlessly incorporates the whole gamut of rules that Synthetic ETFs must have in place when receiving collateral including UCITS concentration limits, ESG constraints, custom index requirements, custom concentration limits, and more.

With automated workflows from Wematch, financial institutions can reduce the time taken to complete collateral optimisation from around 4 hours to just 15 minutes – and with certainty that collateral is optimized in line with client requirements and downstream compliance obligations. Digitised collateral management is therefore a significant new competitive level for dealers in the synthetic ETF space. To learn more, reach out.

Pic Credit: Photo by Jose Silva from Burst

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